Many financial people – perhaps even most – recommend that you get out of debt as soon as possible, and stay out of it for ever and ever. But is this always the best advice?
We’re going to take a look at the counter-argument here, that there is such a time and circumstance when having debt is actually a good thing. That isn’t to say that debt is good at all times, but only that certain debt, under certain terms, and at certain times is better to have than not. You won’t be reading anything here that will suggest that borrowing money for a vacation or a shopping spree is in any way the right thing to do.
Use Debt As Leverage To Build Wealth
Most of us don’t have enough money to make large purchases, such as a home or a business, by paying all cash. Debt will be a part of the purchase, and that might not be a bad thing.
As a rule, if you can borrow money at an interest rate that is lower than the return on your investment, then borrowing the better way to buy.
For example, if you can borrow mortgage money to buy a house at 4% per year, and you expect the property value to rise by something better than 4% annually, then you would be better off borrowing to buy the house than to pay cash for. Similarly, if you borrow $100,000 at 10% interest to buy a business that you expect will give you an income of $50,000 per year, that could be good debt. You’re paying $10,000 in interest to buy a $50,000 cash flow.
In both examples, if the loans that you are using to make your purchase are fixed rate, self amortizing loans – and they usually are – the benefit will be even greater once the loans are paid off. You will have leveraged your money to great financial gain.
Debt Can Be A Hedge Against Inflation
Simply put, if you borrow money at 5% and the rate of inflation rises from 3% to 10% you will be in a position to pay back your loan in cheaper dollars than when you received the loan. In addition, since inflation will be higher you will almost certainly be able to earn a larger return on your money. If inflation is running at 10%, you should be able to get 7% or 8% in safe investments like CDs and Treasury bills.
In such a circumstance, you will be earning 2% to 3% above the rate you borrowed at. That arrangement will continue as long as the loan proceeds are outstanding. In the meantime, it’s a complete financial win for you.
Interest Rate Matters
In order to qualify as good debt, the interest rate you’re paying on a loan must be an advantaged one. That means that the rate on the debt must be lower than the return that you can earn in other investments. For example, stocks have historically averaged an 8% annual return over many decades. If you can borrow at rates that are below 8%, then the debt may be a good one.
In today’s record low interest rate environment, it’s not very hard to do. Mortgages, auto loans, and even some credit cards carry rates that are well below 8%. That isn’t to say that any debt is a good one as long as you could borrow for less than 8%, but only that one major criterion of good debt has been met.
If for example, you could borrow money to buy a car at 4%, and move the amount of money that you would have paid for your car into a tax-sheltered retirement plan earning 8% in stocks, by the time the auto loan is paid you will be richer than you would have been had you never taken the loan in the first place.
Always Fixed Rates Over Adjustable Or Revolving
The debt scenarios covered above are only worth taking if the loans are fixed rate and self amortizing. Though there may be some risk that the value of the house, the income from a business, or the return on stocks will not turn out as hoped, the loan will be paid off in a specified amount of time, and the interest rate will be locked in for the term.
This same arrangement will not be advisable if the type of debt were revolving and carrying either an adjustable or variable interest rate. Anytime you borrow money in an effort to make more money, you’re taking on a certain amount of risk. Revolving debt will magnify the risk to unacceptable levels. In fact, all of the advantages of borrowing at low rates will be meaningless if those rates can rise in response to changing circumstances. This is true even if the revolving rates that you can obtain now are lower than fixed rates. The absense of a rate ceiling makes these loans bad debts from the start.
We are in a period of historic low interest rates; any money that you borrow now should be locked in at those rates. This can represent a one time borrower windfall that will not extend to adjustable and variable interest rates.
As long as you use low interest, fixed rate, self amortizing debt to purchase income generating assets – the kind that are likely to provide greater returns than you’re paying in interest – then you are probably looking at a good debt arrangement.
Can you think of other situations where debt would be considered good debt?